18 May 2018
Global share markets were mixed last week with Japanese and Chinese shares up 0.8% and Australian shares up 0.5%, but Eurozone shares flat weighed down by a fall in Italian shares and US shares down 0.5% on the back of rising bond yields and geopolitical worries. Bond yields mostly rose led by strong data out of the US and the spread between Italian and German bonds widened as investors worried about a populist government in Italy. Oil prices rose but gold, copper and iron ore prices fell. A further rise in the US$ weighed on the A$.
US-China trade talks with China’s Vice Premier Liu He have proved “constructive” with China pledging to reduce its trade surplus with the US, buy more US goods and services and toughen intellectual property laws. A trade war has likely been averted. This is very positive. There is a long way to go to work out the details but it’s clear that the US and China have started a constructive process to resolve their differences and have agreed to stop “slapping tariffs” on each other. The risk of a growth debilitating trade war between the US and China has now subsided substantially. The US tariffs on Chinese imports that were due to be finalised by May 21 will almost certainly be put on hold. Both sides can claim victory here – President Trump can claim that his strategy of putting maximum pressure on China regarding trade and intellectual property is working and China will benefit by putting its trade relationship with the US onto a more sustainable footing. This news is positive for global share markets as investors had been fretting ahead of the May 21 deadline. Shares in US companies with significant exposure to exports to China will be key beneficiaries. But it’s also a big positive across Asia and for Australian resources stocks given supply chain linkages to Chinese companies that export to the US. There is a long way to go in terms of specifics, but this development adds to confidence a negotiated solution will be found to the US-China trade dispute and that a trade war will be averted.
Investors finally awaking to the risks around a populist Five Star Movement and Northern League government in Italy. While they are yet to agree a Prime Minister, they are proposing big tax cuts, a basic income, a roll back of pension reforms and a review of EU budget rules. The resultant budget deficit blow out will create tensions with the rest of the EU and put upwards pressure on Italian bond yields with NL leader Matteo Salvini naively bragging that “the spread [between Italian and German bond yields] is going up – do you remember the spread?”. It seems investors do and the spread between Italian & German bond yields rose by 0.37% over the last week and this is now weighing on Italian shares which fell 2.9% over the last week. Market & economic realities may eventually force 5SM and NL to water down their policies in government – which may explain why the leader of neither wants to be prime minister! In some ways this has echoes of the experience of Syriza in Greece that promised extreme populist policies but became just another centrist European political party. An Itexit is not an imminent threat and the risk of contagion to the rest of the Eurozone is far less than it was when Grexit was talked about as other vulnerable countries like Spain are now in much better shape and popular support for the Euro is solid. But a 5SM/NL Government will be bad for Italian assets and poses some risks for the Euro.
At least another spread is falling & that’s the US Libor-OIS rate spread (or the interbank lending rate less the expected Fed Funds rate) and the bank bill rate less expected cash rate spread in Australia has followed. Such spreads have fallen by 0.15% or so over the last few weeks – this is taking pressure off bank funding costs thereby reducing the risk that Australian mortgage rates will rise in compensation. However, a threat to mortgage rates from rising global bond yields is building.
Rising oil prices flowing through to petrol prices and cutting into spending power. Reflecting strong global demand, falling inventory levels and the threat to the supply of Iranian oil, global oil prices have risen around 45% over the last year and this has driven a sharp rise in Australian petrol prices from around $1.25/litre to around $1.45/litre. The lag from higher oil prices to higher petrol prices suggests Australian petrol prices may rise another 3-4 cents/litre in the next week or so.